Interest Rates Uncertain

Posted on: 16 June 2008 by Gareth Hargreaves

Graham Kerner's weekly look at the world of stocks & shares plus other finance news.

Inflationary concerns were at the fore last week with investors on alert as central bankers seek to curb upward pressures by raising interest rates. The market gave up some of the previous week's gains as investors remained unsure about how much interest rates may go up. Oil remained high and prices may rise next year.

The FSA clamped down on short-selling which gave a much needed fillip to the banking and house building sectors.


Attention turned away from the equity markets to the bond - fixed-interest - markets last week as investors became more concerned about the outlook for global inflation and specifically what steps policymakers might take to curtail it.

The shift came after Ben Bernanke, chairman of the US Federal Reserve, warned of growing inflationary pressures, bolstering the view that the world's leading central bankers are now on high alert. Last week data showed that US inflation hit 4.2 per cent during the year to May. As The Financial Times noted, the ECB's president recently caused an upset by intimating that Eurozone interest rates would rise next month, and although the bank moved last week to correct the impression it was the start of a series of increases - officials signalled the rise is likely to be a one-off.

With a series of interest rate rises now priced into markets in the US, UK and Eurozone, bond yields rose to reflect the view - in the UK short-dated gilt yields have risen a percentage point in the last month. These sudden market movements show traders think central banks will not allow inflation to rise on the back of high energy and food prices without some reaction.

There was plenty of evidence that upward pressures remain. In Chicago the price of corn broke through the $7-a-bushel level amid mounting concerns about the outlook for this year's crop. The other main contributor to inflationary woes is of course crude oil where the price of a barrel remains close to its all-time high of just under $140 per barrel.

The reasons behind the doubling of prices over the last two years has led to much debate and only last week finance ministers from G8, whilst warning that higher prices are creating significant headwinds for the global economy, were split on the cause.

The Sunday Telegraph reported that some, such as Alistair Darling, were taking the view that it's not just the speculators who are to blame but rather a reflection of long term trends in global supply and demand. As to where the price is going, Russian energy giant Gazprom added fuel to the fire by warning that oil prices could almost double to hit $250 a barrel by next year. Joining the debate Tony Hayward, CEO of BP, rejected as a "myth" the idea that high prices were caused by speculation and similar technical factors.

However as The Financial Times opined, whilst analysts say it's a bubble about to burst - oil prices have risen 730% from the low of 2001 - prices could still rally further in the short-term.

Short & Sharp

Talking of short-term, traders were given an unexpected rap across the knuckles by the UK's market regulator, the Financial Services Authority, as it decided to get radical with short-sellers. In an unexpected move the FSA unveiled a change in rules in an effort to discourage short-selling - where traders sell a share hoping to buy it back cheaper, thus making a profit - in shares of companies in the midst of raising fresh capital.

In recent weeks several companies, most notably Bradford & Bingley and HBoS, have seen their share price slide below the rights issue price raising concerns about companies ability to seek extra capital. The FSA's move gave a welcome boost to the banking sector generally and particularly HBoS with the house building sector reaping benefit too. The parlous state of the housing market has led to concerns that a number of leading house builders will be forced to raise fresh capital to shore up their balance sheets. So by the end of the week, shares in the bank and house building sectors enjoyed a welcome bounce although the broader market retreated as investors mulled over inflationary threats.

Not So Des Res

As the weeks progress there just seem to be more problems emanating from the residential property market - and not just in the UK. The Sunday Telegraph reported that America's housing crisis is reaching serious levels as the number of people losing their homes and those behind on mortgage payments soared last month. Apparently one in every 500 American mortgage holders has either lost or is on the verge of losing their home.

Fortunately, here in the UK things are nowhere near as bad although, according to The Sunday Times, the threat of negative equity for more recent homebuyers is lurking in the background. For good measure, the Royal Institute of Chartered Surveyors announced that 93 per cent of its members reported a fall in house prices in May. This co-incided with comments from the Governor of the Bank of England, Mervyn King, when he said that the recent financial "party" of cheap credit and excessive risk taking might mean "innocent bystanders" losing their homes.

On the positive side, house builders are fighting back and Taylor Wimpey is offering to lend house buyers a quarter of the value of a new-home, interest free for ten years in an effort to sell more homes. Which is something estate agents would like to do too. The Daily Telegraph highlighted the plight of many agencies who in response to seeing sales fall by around half, are having to let staff go or are even going under.

Whilst the immediate ramifications of the credit crunch are easy to see The Sunday Times looked further ahead - to retirement. The paper said that almost 3 million homeowners are relying on equity in their property to fund retirement - either via equity withdrawal or downsizing - but that with falling prices those seeing their home as their pension pot could find their plans in disarray. About 16 per cent of homeowners depend on accumulated wealth in their property for their pension according to research by Business Development Research Consultants.

Current events are of course a salutary reminder of that old adage not to put all your eggs in one basket - having a separate retirement plan reduces the risk of having to defer retirement and HM Revenue and Customs will contribute anything up to 40 per cent by way of tax relief on contributions.

Voices Of Experience

Current market conditions are undeniably challenging but the volatility does create opportunity for experienced investors and John Hodson of THS Partners is of that ilk.

"Our basic approach is to seek out companies where we can see growth opportunities ahead but that are trading on reasonable price multiples - for whatever reason - and then take a three to five year view, so patience is required. Our compare and contrast approach means that once we have identified a theme then we will seek to buy a company that fits and we will look globally.

"Current market conditions are not new, we have been here before but each time it is slightly different. This time the speed of events is a reflection of instantaneous news flow and trading which creates some of the extreme volatility we are witnessing. Of course the corollary is that it also creates pricing anomalies and what I mean by this is that when a sector falls out of favour the mark downs are indiscriminate and good companies suffer along with the poor ones. If we didn't have these anomalies then our ability to outperform would be curtailed so we are using current events to buy at lower levels and then wait.

"Interest rates are unlikely to fall from here because central banks are, rightly, worried about inflation and in some places rates might go up which will hurt highly leveraged companies so we are avoiding those businesses.

"Oil has gone up too far too fast and whilst it may go higher I don't see it reaching the much vaunted $250 per barrel figure. Of course it is unlikely to fall back to the low levels of recent years because the marginal producers find it economical at $80pb to extract oil from sand so the floor on oil prices has now been raised. We are continuing with our clean energy theme and like solar power where we see great opportunity - in places like California peak demand co-incides with peak output which is highly efficient.

"We have played the emerging market story for a long time now but developing economies have a bigger inflationary problem than the West and this view is now reflected in the portfolio.

"As to where we are now and whether the credit crunch is over I guess we are, on past experience, about halfway through. There is a strong correlation between consumer confidence and the stock market with the real economy lagging both. Currently consumer confidence is down to levels seen in the Nineties - the last time there was a recession - implying equities are at a lowish point. The speed of correction in prices in some parts of the markets, for example US asset prices, means there is serious value emerging and fortunately we have a substantial cash-cushion to take advantage of these unusual opportunities. So whilst we may possibly see prices going lower in the short-term the bigger picture is beginning to look more encouraging".

Ian McVeigh manages the UK equity element of the St. James's Place Cautious Managed Fund and he is positive about the outlook.

"Experience has taught me that the best returns are achieved when things look bad - in other words investing at times like these means you will achieve good returns later on by buying quality companies that are cheap and there are plenty of those out there at present. Valuations in bombed-out parts of the market are at levels not seen for many years and whilst some of these may be value-traps, there are good companies offering great value for investors. So, taking a two year view, we set price targets for stocks and from here many stocks offer 30-40% upside.

"Whilst the last year has been difficult for equities, I am firmly in the camp which believes that, with investor expectations of equities at a low point, the upside is high. The fund is roughly fifty-fifty fixed interest and equities which creates a good balance and the fund has been stable in exactly the way it should during these difficult times.

"But right now I continue to own mining stocks and having avoided the value-trap of the banking sector through the crisis I am now buying HSBC. Oil looks like a bubble and I think demand and supply will adjust. So I think the outlook is actually a lot better than most people believe".

16th June 2008

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